2 Stock Market Risks That Every Investor Should Know

We live in an age of abundance today when it comes to information.

Case in point: It is estimated that 90% of  the data that exists in the world today was generated in the last two years alone. This explosion of readily-available information comes with a challenge – managing that vast ocean of data we have to reach useful conclusions.

The challenge in managing data applies to investors as well, as the deluge of data available about the financial markets may pose certain risks that investors should be mindful of. Here are two such risks to note.

Risk No. 1: Overconfidence

Focusing too much on noise from the financial media can lead to several dangerous traps for investors.

One is overconfidence, which arises from the psychological phenomenon that because you have so much information, you think that you must know everything there is to know about a company or the economy and therefore your investment assessments will be spot on.

Thing is, more information need not necessarily lead to better predictions about the stock market’s future.

The chart below shows Wall Street strategists’ forecasts of the stock market’s returns and the market’s actual returns. As you can see, even the top financial minds in America’s financial capital are prone to consistent errors which make their forecasts of future market returns as useful as having a toothpick in a swordfight.

Wall Street Prediction vs. Actual Barrons

As alluded to earlier as well, there has been an explosion in the amount of new data created in the world over the past few years and it’s very likely the stock market’s also been part of the phenomenon. Yet, as the chart shows us clearly, the strategists haven’t exactly become more adept at predicting the market’s short-term future.

Instead of trying to predict next year’s returns (and risk having to face the highly likely outcome of being dead wrong), the common investor could do better by simply investing for the long-term.

Risk No. 2: False Precision

“It is better to be vaguely right than exactly wrong” – Warren Buffett

Another risk that investors face from excessive informational noise is the propensity to fall prey to false precision.

Take for instance, valuation models. Some may have valuation models with hundreds of inputs to deliver a precise figure for the “value of a stock” that goes down to three decimal places. However, a precise figure is not the same as a correct assessment and this is an important distinction.

After all, any valuation may be only as good as the business that is being valued. If the underlying business faces issues that we did not foresee, its share price may still go down despite our most precise estimates of its value.

With that, the next time you head to the stock market to invest, keep these two risks in mind. It may keep you from making errors that may harm your future returns.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chin Hui Leong doesn't own shares in any company mentioned.